From its intra-day high on January 28th, the S&P 500 dropped to an intraday low of 12% below that last Friday before recovering a bit near the close.

What’s going on?

As I see it, at any given time, liquid investments (i.e., stocks, fixed income, cash) are in a rough kind of equilibrium. If the price of one of the three changes, sooner or later the price of the others will, too.

What I think the stock market is now (belatedly/finally) factoring into prices is the idea that the Fed is firmly committed to raising interest rates away from the intensive-care lows of the past decade. That is, rates will continue to rise until they’re back to “normal” –in other words, until yields on fixed income not only provide compensation for inflation but a real return as well. If we take the Fed target of 2% inflation as a guideline and think the 10-year Treasury should have a 2% real return, then the 10-yr yield needs to rise to 4% — or 115 basis points from where it is this morning. Cash needs to be yielding 150 basis points more than it does now.

One important result of this process is that as fixed income investments become more attractive (by rising in yield/falling in price), the stock market becomes less capable of sustaining the sky-high price-earnings ratio it achieved when it was the only game in town. PEs contract.

Stocks are not totally defenseless during a period like this. Typically, the Fed only raises rates when the economy is very healthy and therefore corporate earnings growth is especially strong. If there is a typical path for stocks during a cyclical valuation shift for bonds, it’s that there’s an initial equity dip, followed by several months of going sideways, as strong reported earnings more or less neutralize the negative effect on PEs of competition from rising fixed income yields.

living in interesting times

Several factors make the situation more complicated than usual:

–the most similar period to the current one, I think, happened in the first half of the 1990s–more than 20 years ago. So there are many working investment professionals who have never gone through a period like this before

–layoffs of senior investment staff during the recession, both in brokerage houses and investment managers, has eroded the collective wisdom of Wall Street

–trading algorithms, which seem not to discount future events (today’s situation has been strongly signaled by the Fed for at least a year) but to react after the fact to news releases and current trading patterns, are a much more important factor in daily trading now than in the past

–Washington continues to follow a bizarre economic program. It refused to enact large-scale fiscal stimulus when it was needed as the economy was crumbling in 2008-9, but is doing so now, when the economy is very strong and we’re at full employment. It’s hard to imagine the long-term consequences of, in effect, throwing gasoline on a roaring fire as being totally positive. However, the action frees/forces the Fed to raise rates at a faster clip than it might otherwise have

an oddity

For the past year, the dollar has fallen by about 15%–at a time when by traditional economic measures it should be rising instead. This represents a staggering loss of national wealth, as well as a reason that US stocks have been significant laggards in world terms over the past 12 months. I’m assuming this trend doesn’t reverse itself, at least until the end of the summer. But it’s something to keep an eye on.

my conclusion

A 4% long bond yield is arguably the equivalent of a 25x PE on stocks. If so, and if foreign worries about Washington continue to be expressed principally through the currency, the fact that the current PE on the S&P 500 is 24.5x suggests that a large part of the realignment in value between stocks and bonds has already taken place.

If I’m right, we should spend the next few months concentrating on finding individual stocks with surprisingly strong earnings growth and on taking advantage of any individual stock mispricing that algorithms may cause.

…to us as individual investors, for the portion of our assets we choose to manage actively.

As of the close of trade in New York last Friday, the Standard and Poors 500 was weighted, by sector, as follows:

IT 24.0%

Financials 14.8%

Healthcare 14.1%

Consumer discretionary 12.1%

Industrials 10.1%

Staples 8.1%

Energy 5.8%

Utilities 3.1%

Materials 3.0%

Real estate 2.9%

Telecom 2.0%.

The goal of active managers is to have better results than the index (I could say “an index fund,” but the two are the same, less the small fees an index fund purveyor charges). We’ll only have different results if we have different holdings than the S&P. And if our holdings aren’t different–either different names or different weightings (or both)–we can’t be better. In order to be different our first job is to know what the index looks like. The list above is a first cut.

Let’s rearrange it to show the sectors in order from the most sensitive to general economic activity to the least. I’m going to divide the sectors into three groups, from those that do best in a red-hot world economy, those that will still do well with so-so growth, and those that have the most defensive characteristics–meaning they do their best relative to the index when economies are contracting.

most economically sensitive

Materials 3.0%

Industrials 10.1%

Energy 5.8%

————————————-total = 18.9%

economically sensitive

IT 24%

Consumer discretionary 12.1%

Financials 14.1%

Real estate 2.9%

————————————-total = 53.1%

defensive

Healthcare 14.1%

Staples 8.1%

Telecom 2.0%

Utilities 3.1%

————————————-total = 27.3%.

I’ve stuck Energy in the most sensitive segment. Recently it’s been marching to its own drummer, as the big integrated oils restructure and as the crude oil price yo-yos up and down. Ultimately, though, I think in today’s world oil is just another industrial commodity that’s not that different from steel or aluminum. Put it somewhere else if you disagree.

This isn’t the only reordering we could make. We could also arrange the index by market capitalization in order to either emphasize big stocks or small ones in our holdings. But this is the most common one professionals, and their institutional customers, use. Personally, I think it’s also the most useful way to think about the index.

To my mind, the most striking thing about the S&P 500 is that it is mostly geared to a rising economy. If we think recession is brewing, tiny changes in holdings aren’t going to make much of a difference in relative performance.

Another–very important–point is that if you have a portfolio that’s, say, 10% Healthcare, and your benchmark is the S&P 500, you’re betting against Healthcare as a sector, not on it.

Last week I got a press release from Factset, a financial data collection and analysis service, on the topic of where the S&P 500 is headed over the coming twelve months. The short answer from Factset: brokerage house analysts think the market is going up a little bit, strategists think the market is going down–again by just a touch.

I’m going to write about this over the next few days. My short answer: if history is any guide, neither outcome is likely. The market seldom drifts along. It either goes up a lot, or down a lot.

strategists vs. analysts

Who are these people?

First of all, they’re both sets of “researchers” who work for brokerage houses. Now, they don’t call brokers the “sell-side” for nothing. The number-one job of any sell-side researcher–analyst or strategist–is to persuade customers to do their trading business with their firm. In other words, they’re primarily salespeople. That’s important because it means that at least to some degree they both tailor what they say to fit what their buy-side audience wants to hear.

strategists

Strategists are typically economists or statisticians by training, although they are also sometimes former portfolio managers (snide pms would probably say failed portfolio managers).

Strategists normally work “top down.” That is, they use data about the macroeconomy to make forecasts about GDP growth and the course of interest rates. They then derive expected future earnings growth for the overall stock market and the price earnings multiple at which they think the market will trade. That gives them a forecast of the future stock market price. For the S&P over the next year, Factset says the strategists’ consensus is down, but my less than 10%.

Based on their analysis, strategists also recommend sector- and industry-based portfolio structure. In conjunction with analysts, the may also suggecst individual stock holdings. They may also help set policy–like the official forecast of the oil price–that analysts more or less adhere to in making their company earnings forecasts.

Strategists are normally much more conservative than sell-side analysts. Their earnings growth projections are almost always lower than analysts’. Clients occasionally permit strategists to be bearish, and–as is the case now–to say the market is headed south. But a prolonged bearish tilt is almost like buying a ticket for the unemployment line.

analysts

Analysts are specialists in specific industries or economic sectors. They may have academic training in engineering or other subjects pertinent to the industry they cover. They may have worked in the industry, often in strategic planning or M&A. They’re invariably deeply knowledgeable about company financials and about the competitive dynamics of their coverage. They often also have privileged access to the top management of the firms they analyze.

That access usually comes at a price. Analysts can come under considerable pressure not to deviate–either up or down–from the official earnings guidance announced by these firms. A “sell” recommendation can sometimes trigger a violent reaction from the company in question.

Many investors–childishly–don’t like to hear bad news about the companies they own. At the same time, the analyst won’t earn much if he doesn’t have good things to say about at lease some firms in his industry. As a result, analysts tend to err very substantially on the side of optimism. They turn bearish, even for a short time, at their peril.

year-ago predictions

Industry analysts make projections of earnings growth and set stock price targets for the companies they cover. They don’t make projections for the S&P. Factset gets an implicit analyst forecast for the market by aggregating the analyst projections for each company in the S&P 500.

Getting a strategist forecast is much more straightforward. Factset just takes a median.

Anyway, in April 2012 the implied analysts’ forecast for the S&P was much more bullish than the strategists–at +11.9% vs. +2.6%.

No surprise there.

What is a surprise (“shock” may be a better word), however, is that the analysts were a lot closer to the actual S&P 500 results of +13.8% (capital changes only).

According to the research firm Factset,the Wall Street consensus is that earnings per share for the S&P 500 index will amount to around $103 for 2012.

For this year, brokerage house equity strategists (a “top down” view) are projecting eps for the S&P of about $109. Aggregating the company earnings projections of brokerage house industry specialists (a “bottom up” view) into an overall S&P forecast yields an eps figure for the index of $113.

If Wall Street is correct about the 4Q12 earnings now in the process of being reported, the S&P has achieved about a 7% year on year eps gain in 2012. (For what it’s worth, the base case for 2012 profits I came up with in my Shaping… posts a year ago was 7.5% growth.)

Strategists are expecting a slight deceleration in eps gains for this year, penciling in a 6% growth rate. Industry analysts are more bullish (as they usually are). Their collective wisdom is that the S&P will post close to a 10% advance.

my take

In looking at the S&P, it’s important to realize than only half the index profits are sourced in the US. The other half comes, in roughly equal parts, from Europe and emerging markets.

the US: As I wrote a couple of days ago, real GDP growth in the US is probably going to be only about 2% this year. This implies nominal GDP growth of around 4%. Profit growth for publicly listed companies, which tend to be the best and the brightest, should be significantly higher. On the other hand, autos and construction, two large industries which I think will be among the better growers, have little direct stock market representation. Let’s say 5% eps growth.

the EU: Zero is probably the right figure for profit growth. If the EU continues to make progress in trying to shape a closer fiscal union, however, the € could continue to rise in value vs. the $. That would create currency gains for US firms with EU exposure.

emerging markets: Recent macroeconomic reports, as well as anecdotal evidence, suggest that emerging markets–especially those in the Pacific Basin–are beginning to reaccelerate. I think a 20% earnings gain is very easily achievable.

On the surface, this result–the same number as last year–may seem weird. There’s no way that the US is going to have as good a year for GDP in 2013 as it had in 2012. However, the point to note is that +7.5% doesn’t have very much to do with domestic profits. It has much more to do with an end to contractionary government economic policies in China et al, resulting in greatly improving profits from the international divisions of US-listed multinationals.

the market multiple?

During 2012, the S&P gained 13.4%, ex dividends, on a 7% increase in eps. The remaining gain of 6% or so is due to price earnings multiple expansion. In other words, despite all the “death of equities” hysteria in the financial media, investors are willing to pay a higher price today for a dollar of S&P earnings than they were a year ago.

Are we at the end of possible multiple expansion?

No one knows. We can say, however, that on a relative basis, the S&P is still trading much more cheaply than bonds. The traditional comparison is to look at the interest coupon on government bonds vs. the earnings yield (1 ÷ PE) of the market. The two should be roughly equal.

As I’m writing this, the 30-year Treasury is yielding 3%. The S&P has an earnings yield of 7.1%, based on 2012 eps, and 7.7%, based on 2013. The two yield figures are miles apart, a situation last seen in the US in the 1930s. If we use the 10-year, now yielding 1.9%, as our proxy for the bond market, the disparity is even greater. It’s possible that any future adjustment will occur solely through bonds becoming cheaper, with stocks never becoming more expensive. But that’s not usually the way things work in the securities world.

There’s a second argument to be made for multiple expansion. It’s that the relatively modest S&P multiple is directly related to the parlous state of economic policy coming out of the White House and Congress. That is to say, today’s stock prices already discount to some degree the future loss of national economic growth and wealth that’s now being cemented into place by the failure of both political parties to address pressing economic concerns of our international competitiveness, continuing high unemployment and continuing deficits. Were Washington to begin to address these serious structural problems, I think the stock market response would be prompt and positive. We can always dream.

Like a stock that’s gone ex-dividend, my mind has gone ex-thoughts on the final day of the year. My family might contend that this is not as unusual as I want to make it out to be. Whatever the case, I can always hope that, like dividends, my absent thoughts will show up in my account as credits in a day or two.

Anyway, this is the best I can come up with on a sleepy New Year’s Eve.

Through last Friday, the S&P 500 was up 14.07% for 2012, year to date, on a total return basis. The index was up 12.52% on a capital changes basis.

The difference?

Total return includes dividend payments as part of the return. Capital changes doesn’t.

In figuring out your performance against the index, the total return figure is the one to use. Looking at standard reference sources, like your broker’s website or the financial news, however, the figure that gets the most prominence is the capital changes one.

There are two historical reasons for this:

–from the mid-1980s until very recently, US Baby Boomers, who have been a major force in the domestic stock market, have been pretty much exclusively interested in capital gains, not in dividend income. So they paid the highest prices for growth companies. Firms risked being typecast as dowdy and unimaginative if they paid large dividends, so they didn’t. The result is that the dividend yield on the S&P has been small, and easily ignored. No longer, though.

–keeping track on a daily basis of inflows and outflows of funds, account by account, is necessary for an accurate total return performance calculation. This was beyond the computer capabilities of the custodian banks I knew for a considerable portion of my professional career. Easier to ignore than to spend the time and money to upgrade staff and computer systems–especially when the calculation didn’t make that much difference.

2012 (and beyond): a different story

Dividends are again a significant component of the total return on US stocks.

2012 has seen a significant number of companies declare large special dividends, making the difference between their stocks’ capital changes and total returns especially large. Take WYNN, which I own, as an example:

Through last Friday, WYNN is just about unchanged, year to date, meaning a capital changes return of 0. The company has paid out dividends of $10, an $8 special dividend + four quarterly $.50 dividends. On a total return basis, then, the stock is up a bit over 9%. Yes, still an underperformer–but not by the margin that just looking at the figures Yahoo or Google offer would suggest.

I’m not sure that 2013 will be a year to write home about as far as capital change in the S&P 500 is concerned (more about this when I post my strategy for 2013). Despite the absence of a spate of special payouts, I think dividends will be at least as important to next year’s total returns as they have been in 2012.